Wednesday, February 25, 2009

Question marks over carbon trading as prices fall

The European Union Emission Trading Scheme (EU ETS) set up as part of the Kyoto Protocol obligations to reduce carbon emissions is the world's largest multi-national emission trading market, covering 40% of EU's greenhouse gas emissions, and has often been projected as an example of how market mechanisms can help save the environment by making polluting fossil fuels unaffordable for industries. However, this blog has supported the view that carbon tax is a better alternative to reducing greenhouse gas emissions and has been inclined towards Greg Mankiw's contention that cap-and-trade schemes are a way of back door corporate welfare.

Julian Glover has an excellent article where he argues that the current low prices of Certified Emission Reductions (CERs) traded in the ETS has defeated the objective of reducing emissions. The low prices mean that the polluters can easily afford to purchase the CERs and continue to pollute, instead of switching over to more energy efficient and environment friendly technologies. As he writes, "Set up to price pollution out of existence, carbon trading is pricing it back in... Intended to price fossil fuels out of the market, the system is instead turning them into the rational economic choice."

The price of CERs (equivalent to a tonne of CO2) have fallen steeply from 31 euros last summer to just 8.20 euros. It is estimated that businesses can be incentivized to move to cleaner fuels only if the price of CERs stay beyond atleast 30 euros. Critics of the EU ETS claim that the EU gave away too many carbon emission permits to companies, thereby causing supply of CERs to outstrip demand.

Supporters claim that while additional permits were allocated to the big polluters so as to cover up for their expansion plans, the ongoing economic crisis had put paid to many of the plans, leaving the market with excess supply of CERs. Further, with factories cutting down on production, many traditional polluters and purchasers of CERs are left holding excess allowances, which they are in turn selling in the market. In any case, all these indicate the flawed nature of the market design.

Critics of cap-and-trade also point out that it is extremely difficult, even impossible, to monitor whether sellers of CERs in developing economies and elsewhere, adhere to their commitment to reduce their carbon emissions. Being associated with and aware of some of the projects which have been granted CERs, I am firmly convinced that it is virtually impossible to police the outcomes.